By Peter C. Earle
Inflation is the wrecker of the worlds. It destroys purchasing power, increases the signal-to-noise ratio of critical prices for entrepreneurs and business leaders, and distorts accounting records. Its uneven effects can make unprofitable businesses and projects appear profitable, and those who are profitable appear to be losers. When it persists, it becomes a major drag on economic growth, increases unemployment and rewards borrowers at the expense of lenders. And depending on its origins, inflation can also facilitate lavish government spending beyond what tax and tariff revenues would otherwise allow.
But a nation need not experience a Weimar-style burst of hyperinflation for all sorts of ruinous effects to materialize. Relatively low levels of inflation will do just as easily as the handful of rare and extreme episodes that have captured the attention of economists and the fascination of internet pranks. A search of the phrases “hyperinflation (is) just around the corner”, “hyperinflation is coming” and “hyperinflation imminent” on Twitter exposes low-level buzz around the idea that any surge in the level general prices is likely to lead to a spectacular disintegration of the price system. It’s not impossible, but it’s extremely unlikely, for a handful of reasons.
1. The Fed’s move in 2008 from a floor system to a corridor system involves the payment of interest on reserves (IOR). This virtually guarantees that a large portion of the money supply stays at the Fed, is not on loan, or is not seeking goods and services. This amount currently stands at approximately $3.2 trillion. If necessary, the Fed could raise the “internal” interest rate, attracting more money in pursuit of essentially risk-free returns.
US Reserve balances with Federal Reserve banks (2017 – present)
2. The Fed currently expects inflation to decline next year, and market participants currently expect the fed funds target to only reach around 3.8% by the end of the year. 2023.
Implied market rates, 1 year
There is also, within the Fed, a rate normalization target, given that 144 of the last 173 months (since January 2000) have been at a nominal level below 1%, negative in real terms. That may not be true, but in light of Volcker’s tenure (during which rates were raised over 20%), there is still plenty of policy room for the Fed to operate. If inflation were to continue to rise or even accelerate, the Fed would simply continue it with higher and higher rates, or increase the balance sheet unwind rate, currently pulling some $95 billion a month out of the economy. American. It could also engage in other less conventional operations. An unusually radical approach to dealing with runaway inflation, and arguably the antithesis of “helicopter money,” was adopted by the Afghan central bank for other reasons several years ago.
3. At present, there is some evidence that markets and consumers expect inflation to be high for a while and then to come down. If the markets are wrong, arbitrage opportunities will appear. Consumer expectations may be wrong, but at present they do not indicate that persistently high inflation, such as that which occurred in the 1970s (and which was also not hyperinflation ), is likely. The spread between the current generic 5-year U.S. government note and the yield on 5-year Treasury Inflation-Protected Securities (OTCPK:TIPS) currently estimates average annual inflation at 2.52% through 2027.
US 5-Year Treasury – 5-Year TIPS Yield Spread (April 2022 to Present)
4. Unlike the Zimbabwean dollar or the Venezuelan bolivar, the dollar is more than a currency. It is a safe haven and a global unit of account. The demand for US dollars is extremely high, although monetary technocrats would be wise not to test the limits of this adage. The global demand for dollars translates into the effective export of some of the inflationary effects of expansionary monetary policy. While this sounds like good news for Americans and not so good news for downstream dollar users, in many emerging markets even inflationary US dollars are likely to be less inflationary than domestic currencies.
Emerging Markets Year-on-Year Inflation Rate (2012-Present)
5. Most previous outbreaks of hyperinflation began with colossal, emergency-driven political partnerships between fiscal and monetary authorities. Two common themes are an order from a head of state or executive body to print money to meet tax obligations on an unlimited basis, or to monetize unsustainable debt. While neither is impossible in the United States, the former is currently illegal and the latter is not, at present, a matter of special requirement. But these are the reasons why the independence of the Fed and the reduction of the stock of US debt are essential.
None of this should, although it probably will, be interpreted as dismissing the dangers of inflation or as giving credence to the Fed’s inflation-fighting expertise. The superlative features of hyperinflationary episodes are exciting to some, carrying cumbersome piles of physical currency to buy simple goods, hourly changing prices, etc., but utterly unnecessary for inflation to destroy economic calculation and peaceful exchange and volunteers. In England right now, the Harmonized Index of Consumer Prices is currently up 10.1% year-on-year, a far cry from the rates that Philip Cagan classified as hyperinflationary in 1956, but nonetheless destructive. The pursuit of sound money is more profitable for identifying outsized monetary policy actions, rather than inconsequentially predicting extraordinary and extraordinarily unlikely outcomes.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.